Short-term rule of thumb: Expect stock market to rise

Many financial pundits like to predict what the market will do in the near future as they urge you to buy or sell “now.”

Unfortunately, they’re often wrong. No one can consistently and accurately know what the market will do in the short term. In the long term, though, the trend is clear: The market rises.

In a famous study, University of Michigan finance professor H. Nejat Seyhun found that an investment held in the stock market from 1926 through 2004 would have delivered an average annual return of 10.4 percent, turning $1 into $1,919. But get this: He also found that if you were out of the market (i.e. not invested in it) for the market’s 12 best-performing months, your average annual return would be only 7 percent. If you sat out the 48 best months, you’d be down to a mere 2.7 percent, turning your dollar into $6.46. Miss just the 10 worst days and your annual average jumps to 12.8 percent.

Much of the market’s gains can occur on just a few days. So anyone who tries to time the market risks missing out on substantial profits. Sure, by being out of the market on the worst days, you’ll improve your returns — but no one can correctly predict when those worst days will occur.

Another problem with market timing is that it can be expensive. Getting in and out of investments frequently can leave you with short-term capital gains (if you’re lucky to have avoided losses) that are typically taxed at a higher rate than long-term gains. Frequent trading can generate lots of commission fees, too.

Over the long run, it’s usually more hazardous to your wealth to be out of the stock market than to be in it. By hanging on, you’ll be in the market on days when it counts and be able to ride out occasional downturns. One good strategy is to regularly invest in the market, no matter whether it’s up or down, perhaps through a broad-market index fund.

Ask the Fool

Question: Do annual reports indicate how overvalued or undervalued a company’s stock is?

Answer: Not usually, but you’d do well to read your holdings’ annual reports anyway. If you’re a novice, at least read the CEO’s letter to shareholders, which offers a sense of management character and the company’s strategic plan. The financial statements can be even more informative. The balance sheet will show you the firm’s financial health at one point in time, including its cash, money it owes, money owed to it, etc. The income statement (sometimes called the statement of operations) shows sales, costs and profits over a period of time, while the statement of cash flows will list all of the company’s cash inflows and outflows during the period.

The more familiar you become with financial statements (perhaps just by reviewing many of them), the better chance your portfolio will have of performing well.

Annual reports don’t focus on companies’ valuations, though. For that, you can look up a company’s current market value easily via online stock quotes. Just click over to a site like finance.yahoo.com, type in a company’s name or ticker symbol, and look for “market capitalization” (or “market cap”). You can also calculate it yourself by multiplying the current stock price by the number of shares outstanding.

A company’s intrinsic, or fair, value is a more elusive beast. Different analysts will come up with different numbers using different assumptions about the firm’s growth prospects, among other things.

Q: What are “basis points”?

A: A basis point is .01 of a percentage point.

So if you hear that some interest rate is down 25 basis points, that means it’s down a quarter of a percentage point.

My smartest investment

Investments that keep giving? Upon graduation from high school in 1941, my first job was as an office boy at DuPont. At Christmas my boss handed me a present of $25, equal to a third of my monthly salary. No one has ever spent as many hours on calculations and projections as to how such a windfall should be invested. The result: I purchased a lifetime subscription to Reader’s Digest. By age 80, that had averaged out to 3.4 cents per issue.

The Fool responds: That’s a great reminder that some of the best kinds of purchases and investments are ones that keep giving for a long time. These include lessons, travel, and even stocks and bonds, as they can expand our skills, knowledge, experiences and wealth.

A great dividend-paying stock, for example, can keep generating income for decades, while it appreciates in value. For instance, Procter & Gamble has been paying dividends for 122 consecutive years and raising them for 56 consecutive years. IBM has been paying quarterly dividends since 1918.

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